Donat Corp.is a small company looking at two possible capital structures.Currently,the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding.The market value of each share is $6.00.The CEO of Donat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares,leaving 50,000 shares outstanding.The cost of debt is 5% annually,and the current corporate tax rate for Donat is 30%.The CEO believes that Donat will earn $50,000 per year before interest and taxes.Which of the statements below is TRUE?
A)All-equity EPS is $0.35.
B)50/50 debt-to-equity EPS is $0.49.
C)Shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity.
D)Statements A,B,and C are all true.

Question

Quizplus · Accepted Answer

To find the EPS for the all-equity structure, we divide the earnings by the shares outstanding:

EPS = $50,000/100,000 = $0.50

Therefore, statement A is false.

For the 50/50 debt-to-equity structure, we need to calculate the interest expense and subtract it from the earnings before dividing by the remaining shares outstanding:

Interest expense = $300,000 x 5% = $15,000
Earnings after interest and taxes = $50,000 - $15,000 x (1 - 0.3) = $36,500
EPS = $36,500/50,000 = $0.73

Therefore, statement B is false.

To find the EPS difference between the two structures, we need to calculate the EPS for the all-equity structure and subtract it from the EPS for the 50/50 structure:

EPS difference = $0.73 - $0.50 = $0.23

However, this difference needs to be adjusted for the change in shares outstanding. Since the company is retiring 50,000 shares, we need to divide the EPS difference by 50,000:

Adjusted EPS difference = $0.23/50,000 = $0.0046

Therefore, statement C is false.

Since statements A, B, and C are all false, the correct answer is D, which states that all three statements are true.